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How Do Employee Stock Options Work?

The practice of granting stock options to employees is growing in popularity as a way for employers to attract and retain talent. And depending on the company, it could pay off big for the employees. Because options give you a stake in your company’s success, you could see a big profit if your company is successful. If you’ve been offered options as part of a compensation package, or if you’re considering exercising and selling those options, it’s a good idea to first brush up on how they work.

What Are Stock Options?

Stock options are a perk that companies can grant to employees, contractors, consultants and investors. Companies grant stock options through a contract that gives an employee the right to buy (also called exercise) a set number of shares of the company stock at a pre-set price (known as the grant price). This offer doesn’t last forever, though. You have a set amount of time to exercise your options before they expire. Your employer might also require that you exercise your options within a period of time after leaving the company.

The number of options that a company will grant its employees will vary between companies. It will also likely depend on the seniority of the employee. Investors and other stake holders also have to sign off before any employee can receive stock options.

How Stock Options Work: Granting and Vesting

To help you understand how stock options work, let’s walk through a simple example. Let’s say you get a job at a new company, and as part of your compensation, you receive stock options for 20,000 shares of the company’s stock. You and the company will need to sign a contract which outlines the terms of the stock options; this might be included in the employment contract.

The contract will specify the grant date, which is the day your options begin to vest. When a stock option vests, it means that it is actually available for you to exercise – that is, to buy. Unfortunately, you will not receive all of your options right when you join a company; rather, the options vest gradually, over a period of time known as the vesting period.

In this case, let’s say the options have a four-year vesting period, with a one-year cliff. A four-year vesting period means that it will take four years before you have the right to exercise all 20,000 options.

The good news is that, because your options vest gradually over the course of this vesting period, you’ll be able to access some of your stock options before those four years are up. In our example, it’s likely that one quarter (5,000) of your options will vest each year over the course the four-year vesting period. So by year two of your employment, for instance, you’ll have the right to exercise 10,000 options.

The bad news is that there’s a waiting period before any of the options vest. This is where that one-year cliff comes in: This means that you will need to stay with the company for at least one year to receive any of your options. If you leave the company before reaching the one-year milestone, you won’t get any options. After you reach that one-year cliff, you’ll get your first 5,000 options (one-quarter of the 20,000); then, your remaining options will likely vest such that you get an equal amount each month for the remainder of the vesting period. In our example, the remaining 15,000 will vest at a rate of 1/36 for the next 36 months, which comes out to about 416 options vested per month.

How to Exercise Stock Options

Once your options vest, you have the ability to exercise them. This means you can actually buy shares of company stock. Until you exercise, your options do not have any real value.

The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well (or poorly) the company does, this price will not change.

Let’s say your four years have elapsed, and you now have 20,000 stock options with an exercise price of $1. In order to exercise all of your options, you would need to pay $20,000 (20,000 x $1). Once you exercise, you own all of the stock, and you’re free to sell it. You can also hold it and hope that the stock price will go up more. Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options.

There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them. Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it costs you to buy the shares.

Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest.

Finally, it’s also important to mention that your options do have an expiration date. You can find this in your contract. It’s common for options to expire 10 years from the grant date.

When You Should Exercise Stock Options

When and how you should exercise your stock options will depend on your individual situation and the price of the company’s stock. Generally, it’s a good idea to exercise options if your exercise price is lower than the cost of that same stock on the market. For example, let’s say you have an exercise price of $1 per share and a share of the company’s stock costs $2 on the market. You would make money by exercising your options and then selling them.

Of course, if you expect that the price of your company’s shares will rise further in the future, then you may want to wait before selling. Remember that once you exercise options, the shares are yours to keep. You can hold them for as long as you’d like. You can also sell them on the market just as you could with stocks from any other individual company.

On the other hand, if the price of the company’s stock is lower than your exercise price, you would lose money by exercising your options. In that case, you should wait for the price to rise before exercising.

Stock Options and Taxes

You will usually need to pay taxes when you exercise or sell stock options. What you pay will depend on what kind of options you have and how long you wait between exercising and selling.

For starters, it’s important to note that there are two types of stock options:

Non-qualified stock options (NQSOs) are the most common. They do not receive special tax treatment from the federal government.

With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W-2. The amount of income reported will depend on the bargain element (also called the compensation element). This is the difference between a stock’s market value and your exercise price. If you exercise 10,000 options at an exercise price of $1 each, but those shares cost $2 each on the market, the bargain element is $10,000 ($1 price difference x 10,000 shares). That $10,000 goes on your W-2 as ordinary income.

When you decide to sell your shares, you will have to pay taxes based on how long you held them. If you exercise options and then sell the shares within one year of the exercise date, you will report the transaction as a short-term capital gain. This type of capital gain is subject to the regular federal income tax rates. If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year.

ISOs operate a bit differently. You do not pay taxes when you exercise ISOs, though the amount of the bargain element may trigger the alternative minimum tax (AMT). When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain elements is treated as regular income. If you hold the stock for at least one year after exercise AND you don’t sell the shares until at least two years after the grant date, the tax rates you pay are the long-term capital gains rates.

The Takeaway

Stock options are becoming a more common way for companies to incentive and retain employees. However, options can be confusing. The terms of your company’s options will be set by the individual company through a contract you must sign. You should familiarize yourself with the terms in that contract. It will tell you how many options the company is granting and the length of the vesting period. The contract will also have the grant price, which is what you will pay when you exercise those options. How and when you exercise options will depend on the price of the shares. There are also income tax considerations, with the promise of lower tax rates if you hold onto your shares for at least one year.

The Next Step for Handling Your Stock Options

If you aren’t sure how to handle your stock options, it’s a good idea to talk to an expert. A financial advisor can help with a lot of the decisions that come with stock options. Make your advisor search as painless as possible by using this free financial advisor matching tool. Just answer some questions about your goals and situation, and we’ll match you with up to three advisors who are in your area and meet your specific needs.

Want to see how exercising and selling you options could impact your taxes? Our free income tax calculator can help you see how the additional income will change your tax bill. And if you’ve held your stock for a long time, our capital gains tax calculator can show you the tax impact of selling.

Derek Silva, CEPF® Derek Silva is determined to make personal finance accessible to everyone. He writes on a variety of personal finance topics for SmartAsset, serving as a retirement and credit card expert. Derek is a member of the Society for Advancing Business Editing and Writing and a Certified Educator in Personal Finance® (CEPF®). He has a degree from the University of Massachusetts Amherst and has spent time as an English language teacher in the Portuguese autonomous region of the Azores. The message Derek hopes people take away from his writing is, “Don’t forget that money is just a tool to help you reach your goals and live the lifestyle you want.”